Friday, July 25, 2014

Should I invest in AT&T and Verizon for high dividend income?

Most readers are probably aware that it has been getting more difficult to find decent values in the current environment. When I ran my screens for valuation, I stumbled upon AT&T (T) and Verizon (VZ), which are telecom behemoths in the US.

AT&T (T) has increased dividends for 30 years in a row. In the past decade, it has managed to increase dividends by 4.90%/year. Between 1984 and 2014, the company has managed to increase dividends by 4.70%/year. The stock trades at 13.70 times forward earnings and yields 5.20%. Check my previous analysis of AT&T.

Verizon (VZ) has increased dividends for 9 years in a row. In the past decade, dividends grew by 3%/year. Between 1983 and 2014, the company has managed to increase dividends by 3.50%/year. The stock trades at 14.40 times forward earnings and yields 4.30%.

The telecom industry in the US is very competitive. Companies like AT&T (T) compete with the likes of Verizon (VZ), Sprint and T-Mobile. In the past, almost all of the profits have been made by Verizon (VZ) and AT&T, at the expense of smaller competitors. An investment in AT&T and Verizon today would presume that the status quo would remain unchallenged, and that Sprint and T-Mobile would be kept weak forever. The service that telecom companies is essentially a commodity. Telecom companies are not utilities, because there is the possibility for switching the provider. Try moving to Saint Louis, Missouri, and then switching your gas, water or electric utility – you can’t. But anywhere in the US, you can switch to another wireless carrier, plus you have other alternatives and very low customer loyalty. There is nothing to stop a customer from switching to another carrier after their contract expires.

It also takes an enormous amount of capital to maintain and continuously upgrade a network that would cover 300 million people in dispersed area such as the US. Long gone are the days when telecom only meant providing voice calls between users in different locations. Now there are technologies such as 3G, 4G, LTE that require constant costly investment to upgrade network. Barriers to entry are steep of course, since it takes tens of billions of dollars to build a network. However, the main competitive advantages available to Verizon and AT&T are those of scale.

There is a risk of technological obsolescence, since new technologies are requiring that telecom companies engage in multi-billion dollars upgrades, merely to keep up with competitors. In addition, there are new technologies which could leverage existing network infrastructure but could be directly competing with telecom companies. For example, 20 – 30 years ago, the price of a long-distance call between New York and San Francisco would have been quite expensive. Today, I can call anyone in the world using Viber or WhatsApp for free, using wi-fi from a device that is connected to the internet.

Currently both AT&T and Verizon have the advantages of scale, which allows them to spread costs of upgrading and maintaining their network over larger pools of customers. This has allowed them to earn hefty profits, and pay the high dividends to shareholders. For example, if you want to advertise your service, it is much easier to outspend your competitor in advertising by spending twice as much as them when you have three to four times as much customers. On a per customer basis however, this advertising is still going to be cheaper.

Another advantage is the fact that in the traditional telecom model, it would be very difficult for someone to set up a new wireless network. This would take tens of billions of dollars to get the network equipment on tens of thousands of cell towers across the US, plus get valuable spectrum rights. Today however, it is quite possible that competing technology platforms might end up destroying value at the traditional telecom companies. Again, I am talking about WhatsApp and Viber. In addition, we do not know if the future doesn’t hold another technological breakthrough, which could replace the cellphone the same way the your landline has become obsolete.

AT&T has recently announced that it would be acquiring DirectTV (DTV). This could help it offer bundled services to customers at a greater scale. It could also pave the way for international expansion beyond TV for AT&T. AT&T could generate synergies from deal. Plus, DIRECTV could easily double earnings within five years $6 billion from current $3 billon. The company has grown through acquisitions in the past, which is why I believe integration risk to be low.

For both AT&T and Verizon, the dividend has not had a very good coverage out of earnings. I always require that there be a margin of safety in dividends when I analyze a dividend paying company. There is a high risk that the dividend be cut sometime in the next decade, given the competitive pressures, high payout ratios, constant requirement for new capital to invest, and commoditized type of service. If you add in the competitive pressures to the high payout ratio, one could see why I have not been excited about AT&T and Verizon as dividend growth stocks. The best probable scenario that I could see for AT&T and Verizon income shareholders is that their dividend keeps up with the rate of inflation. Even during the past 25 years, the best that AT&T and Verizon could do was grow dividends by 3% - 4%/year. As a result, I would take a pass on both stocks. However, it could be a decent holding for someone who needs high current income for the next decade, and is fine that this income lose purchasing power over time.

An investor in a high yielding company company like AT&T could reinvest their dividends and grow dividends by the 5% dividend yield and the 1-2% organic dividend growth. This means that a holder of AT&T shares worth $30K will receive approximately $1,500 in annual dividend income, which would be then used to purchase 5% more shares. In the next year, the dividend will increase by 2% and the investor will earn the higher dividend on the increased amount of shares. If you rinse and repeat this exercise for 18 years, it is highly likely that the investor will be earning $5,000 in annual dividend income from this position. This is due to the power of reinvesting high dividends into more shares of a high dividend yielding stock that has some dividend growth. If I stop reinvesting dividends however, I income will lose purchasing power to inflation. The risk is also that a high dividend yield is due to a high payout ratio. If the business faces strong headwinds, this increases risk that dividend is cut if times get rough.

However, the opportunity cost of investing in an AT&T is a company like Coca-Cola (KO) or Johnson & Johnson (JNJ), which yield around 3% today, but grow dividends at 7%/year. Of course the 7% figure is very conservative and at the low range of my projections for those companies. In 18 years, I will be earning $5000 in dividend income, if I reinvest those growing dividends. In addition, once I stop reinvesting dividends and live off them, the dividend growth will protect purchasing power of income from inflation. To top it off, the portfolio would also have much higher appreciation potential relative to the AT&T centric portfolio. The drawback is that forecasting dividend growth over an 18 year period is tough, since no one knows what the world will look like in 2032.

In the matter of full disclosure, I do have a tiny position in Verizon, as a result of my investment in Vodafone (VOD) last year, which distributed those shares after selling their Verizon Wireless stake to Verizon. I think that Verizon owning 100% of Verizon Wireless is a good thing for the company, and could end up being accretive for long-term holders. I would probably hold this, since this tiny position is spread out in several tax-deferred accounts. At least I am able to reinvest those distributions automatically. Other than that, I am not planning on adding any money to either AT&T or Verizon, since I believe there are better uses for my capital. I usually invest for the next 30 years, which is why companies that have poor growth prospects are usually at the bottom of my list for purchase.

16 comments:

Good article. Do you find it challenging to assume that the inflationary rate is always a 3%? Politics aside, I have a hard time using the same number for financial planning purposes. Then again, I suppose it's better than not assuming anything.

Historical inflation has been at 3% over the past century or so. It can go much higher in the short run, or go below 3% too. I honestly focus more on at the very minimum preserving purchasing power of principal and income. The more likely scenario is where purchasing power of income and capital increase over time from organic sources.

The preference of JNJ type companies over T or VZ makes sense. But I noticed reference to KO growing dividends 7% per year. I think that is optimistic. The payout ratio is up there now and their growth in EPS has stalled. The major product is carbonated beverage whose volume is shrinking in the big markets.

You are correct that KO has had flat EPS for some time now. However, KO's operations are not limited to US soda sales. It also sells other types of non-CSD beverages in the US; plus do not discount the fact that the company has operations in 200 countries. There is still tremendous opportunity for the company. They supply 3% of drinks worldwide (1.8 billion 8 ounce servings vs 50 billion 8 ounce servings per day globally - I am quoting from memory so the exact number of global might a little off, but by not much). I think KO is not cheap today, which is why I have been building position using puts.

The problem is that either you or your spouse ( or hopefully both) are likely to have 30 years ahead of you in retirement. This is why focusing only on the highest yielding companies might not be best. Some moderate yield and moderate dividend growth stocks might be helpful in preserving purchasing power and providing opportunity for dividend growth over time.

I purchased T this week. While I agree a lower yield that grows faster is typically better, in a market as high as this I would rather own a low PE (defensive stock) than a market + PE aristocrat like JNJ. Time will tell, but I think the bar is low for T and they have some ability to grow with Uverse and Dtv. While JNJ is priced for success and they may or may not hurdle that in the next 4 quarters.

Its about timing, and the time was right for T. Wish I would have thought of it $3 ago, but still.....

You are correct, I didn't even mention anything related to fixed line telecom services, which are cash cows for both VZ and T. I just don't know how to feel about a business that lays out tens of billions in capex, and then others use that capex at almost no cost. ( by others meaning skype, viber, etc)

That being said, T and VZ could likely keep paying high dividends to people for a long time, which is why many retirees will go there, attracted by the yield. I am afraid however that most people simply go for the yield first, and don't bother about anything else from the business.

I avoided telecoms until recently when I bought T. Here's the insight that changed my mind.

T and VZ are not just phone or wireless companies. They are also the owners of the internet backbone. If AT&T, Verizon, Comcast, and Time Warner decided to shut down the internet, we would have no internet or very little internet service in America. They are going to push through anti-neutrality legislation because that's an easy path for them to make more money out of this huge resource.

Owning the internet is a form of power that is extremely valuable so I decided to own my share.

Interesting article...I forgot where, but recall reading a recent post from someone else who also made the same argument that dividend growth (over time) will perform better than a high yielder with little to no growth. I wasn't initially but must admit I am a believer and now chaser of dividend growth. :) AFFJ

What are your thoughts on AMT? They own towers. I had a full position for a few months and made a little $ then I got cold feet and sold, now I'm thinking of buying back in again and would really appreciate your input.

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